By Henry Qin  

Since Chinese insurer Anbang bought the iconic Waldorf Astoria hotel in New York less than three years ago, Chinese investors have been snapping up hotel real estate around the world, leaving footprints in global gateway cities and small European towns alikeHowever, many of them have never invested in hotels or even real estate beforeWho are they and how do they assess hotel investments?  

 

WHO ARE THE INVESTORS? 

The Chinese outbound hotel investors (“the investors”) are a diverse and sometimes random group of companies and individuals. They can be classified by a set of parameters on a few dimensions: investment theme, size, horizon, return expectation, risk tolerance, and financing structure; execution capability – project management expertise, decision making efficiency and resources; and experience with hotels – positioning, brand, distribution, design, and asset management.  

By ownershipthe investors fall into state owned enterprises (SOEs), privately owned enterprises (POEs) and individuals. SOEs and POEs can be listed or non-listedBy business focus, they include real estate developers, insurers, private equity firms, conglomerates, construction engineering firms, tourism operators, and hotel management companiesBy investment objectives, there are long-term “yield seekers”, for example insurers and certain SOEs; strategic investors like funds with clear holding periods, return targets and asset allocation needs; trend riders”such as tourism operators who set to take advantage of the outbound travel boom; and high net worth individuals who use hotels to park excess cash.    

As an aggregate groupthe investors strike a tone of being opportunistic. A niche segment, outbound hotel investing caters to their specific needs and wants, which are not necessarily comparable to those of other hotel investors. Typical motivations of the investors include: exploiting opportunities in undervalued hotels for better returns; allocating capital for diversification asset class and geographycapturing fast growing outbound travel demandsynergistic expansion along value chainscurrency hedge in the backdrop of expected RMB depreciationtaking advantage of low costs of capital; reaping benefits such as increased brand awareness and reputation boostand undertaking political duties for the government. While some of them are one-off players, those who already own hotels in China are more likely to make recurring investments.  

 

WHY HOTEL INVESTMENTS ATTRACT CHINESE INVESTORS 

 Overall, Chinese investors have an affinity for real estate. Hotel real estate appeals to the investors because of their “physicalness” and hence perceived sense of security, reasonable risk-adjusted cash on cash returns, the extra layer of assurance from the value-adding management modeland in some cases the vanity of owning landmark or trophy properties.    

The investors’ return expectations and requirements vary extensively. While a small number of sophisticated institutional investors are comfortable with market returns, some others expect what is normally offered only by opportunistic real estateA going-in unlevered yield of 6-8 percent, and/or an unlevered IRR of 10-15 percent are common return hurdles seen among the investors.  

In general, the investors are optimistic about return prospectsThe optimism reflects a widely held conviction that overseas hotels are more investable than those in China.  However, such optimism can more or less be dampened when they are presented with pro forma financials of investment targetsWhen that happens, they end up having to recalibrate their expectations and reconcile them with the numbersRationally priced hotels in developed and liquid markets do not easily resonate with the rosy expectations built up during the bull run in Chinese real estate. 

 

HOW CHINESE INVESTORS ASSESS HOTEL RETURNS AND RISKS  

Taking a static view toward returns is prevalent among Chinese hotel buyersRoutinely, they tend to focus on going-in unlevered yield, but are not necessarily accustomed to factoring in how value drivers such as locationoperation, asset management and (re)financing create value holistically over timeThis static view usually indicates lack of a clear investment strategy.  Not surprisingly a 4-6 percent going-in unlevered yield for prime locations in global gateway cities is not automatically attractive to the buyersthus developing and articulating a line-of-sight strategy underpinning a higher IRR is essential in any investor pitch.  

A majority of buyers are inclined to screen investments by using one or two basic return measures. “What is the return of this hotel?, or I will consider investing only if the return is above x percent is what you hear frequently. In most cases, by return they mean either going-in unlevered yield, or stabilized unlevered yieldusually on an after-tax basis. They rely on going-in unlevered yield as a deciding factor so much that an unimpressive one could easily have a deal pulled off the table.    

When it comes to more sophisticated return and valuation discussions, it is not uncommon to encounter the following: undistinguished use of yield and cap rate, reluctance to address reversionary value due to unpredictability of exitand the view that exit cap rate will or should be lower/compressed versus the going-in cap rate. Stakeholders such as brokers, banks and hotel operators should address such misconceptions and concerns head on.  

It is common for the investors to believe that hotels offer stable cash flows and income, and therefore are low-risk investments. Not fully aware of the almost unavoidable volatility caused by macroeconomic cycles, demographic shift, supply demand dynamics, operator change, and reflaggingthe investors are likely to underestimate risks.         

It is equally common for them to overestimate risks. This is evidenced by frequent requests from buyers for risk mitigators or performance enhancers such as preferred returnsperformance guarantee, tax abatements and buy-back arrangement to name a fewIt is also quite usual for an investor to negotiate with hotel operators about adding extra checks and balances in the hotel management contract. For example, some buyers would even push for penalty clauses for budget overrun, believing stringent control over operations means better risk mitigation. Sometimes such buyers can cause delay or even an impasse in the deal process by requesting too many self-protection mechanisms by normal industry standards.  

 Many investors treat or use cap rate only as a return metric but not as a risk measure. As such they often use cap rate as a return hurdle. For example, those who require a 6 percent initial yield in preliminary assessment would probably accept deal offered at 8 percent cap rate. At the same timethe investors are easily underwhelmed by low cap ratesfor example those in global gateway cities, reckoning that such hot markets should offer higher returns yet missing the fact that these markets have lowest risksbid-up prices and possibly lower growth potentialWhile expecting higher cap rates, buyers rarely associate such rates with higher risks. Therefore, it is vital to have good storylines on cap rates and risks from the outset of any deal, especially currently when hotel cap rates are close to historical low. Cap rate, which is independent of the ROI or net operating income of any specific hotel, and is market dictated by product type, location, credit availability, inflation, and yield curvesremains much misunderstood concept to a fair number of Chinese investors.   

The fact that hotels are exposed to both business performance risk and real estate market risk, and that there are no standardized and straightforward risk measures, makes it hard for the investors to evaluate risks effectively. 

 Outbound hotel deals are strenuous endeavorsAs a significant component of the larger macro trend of investing overseas, this wave is widely believed to continue. The better we know the investors, the higher the probability of deal success will be. 

(Editor’s Note: May vary slightly as published.)

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About the Author
Henry Qin
Henry Qin
Asset Manager

Henry Qin (秦涵栩) is a senior director, global corporate finance mergers & acquisitions at IHG. He has over 15 years of experience in investments, business development and corporate strategy. Starting as a portfolio analyst on the buy side, he assumed various roles with investment banks in the U.S. and China. In recent years, he has been working in house and is involved in a variety of cross-border transactions. He deals extensively with Chinese outbound investors.

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